Broker Did Not Prevent Misuse of Material Nonpublic Information
Sidoti & Company, LLC, a registered broker-dealer, paid $100,000 to settle charges by the Securities and Exchange Commission (SEC) that the company had failed to establish and enforce policies to prevent the misuse of material nonpublic information (MNPI).
According to the SEC’s settlement agreement, Sidoti started out as an independent research firm that published notes and reports on certain small and microcap public companies. It later expanded by offering brokerage services and investment banking, including selling the securities of companies covered by its research department.
In 2014, Sidoti established a hedge fund managed by its founder/CEO through his control of the fund’s general partner and investment adviser. Sidoti had policies that were meant to prevent the misuse of MNPI by its investment banking and research departments, but those policies didn’t prevent the CEO and associated persons from misusing MNPI obtained from these departments when they made trading decisions for the fund.
For example, Sidoti maintained a Daily Restricted List of securities that Sidoti employees, including its CEO, were not allowed to personally trade. But between November 3, 2014 and May 5, 2015, there were 126 instances when the fund traded in a stock that appeared on the Daily Restricted List.
In response to concerns raised during an SEC examination, Sidoti implemented policies that were intended to prevent the misuse of material nonpublic information by creating information barriers to address the CEO’s conflicting roles in research, investment banking, and advising the fund. Among other things, the policies restricted Sidoti’s associated persons from causing the fund to trade in Daily Restricted List securities, required physical separation between different divisions, instituted email monitoring, and prohibited employees from participating in both research and sales calls.
But the procedures were not reasonably designed to enforce those information barriers. As a result, Sidoti willfully violated Section 15(g) of the Exchange Act, which requires registered brokers and dealers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI.
“Sidoti did not devote sufficient resources to set up the requisite trade surveillance and compliance systems and failed to meet its obligation to prevent the misuse of material nonpublic information,” said Andrew M. Calamari, Director of the SEC’s New York Regional Office.
Sidoti made an offer of settlement without admitting or denying the SEC’s findings. In accepting Sidoti’s offer, the SEC considered the fact that Sidoti cooperated with SEC staff and took remedial steps that included discontinuing its advisory operations and retaining compliance consultants to assess and revise its supervisory processes and written supervisory procedures.
In law firm Morrison & Foerster’s securities industry blog BD/IA Regulator, Jay G. Baris discussed a 2015 settlement between the SEC and another company for failing to prevent misuse of MNPI. According to the SEC, a broker-dealer and an affiliated asset manager shared information, even though information barriers were in place. According to Baris:
This matter underscores the importance of creating and enforcing information barriers that separate trading and investment management functions. By sharing material non-public information across the barrier, affiliated firms risk a “blending” of information among affiliates, creating opportunities that other market participants did not have. The SEC focused on the fact that the affiliates simply did not enforce written policies and procedures in place. The case is a not so subtle reminder that the SEC views prevention of insider trading as a compliance priority.
In an article on implementing information barriers, Kerry S. Burke, of Covington & Burling LLP, and Brandon K. Gay of The Carlyle Group advise that:
While information barriers may not be appropriate in all cases, a well-crafted information barrier—in conjunction with a robust compliance program and routine monitoring—can provide a level of assurance that a firm is taking seriously the potential risks associated with insider trading and responding appropriately.
In this case, distributing a list of restricted securities was a far cry from an effective program to prevent the misuse of material nonpublic information: it was more like just checking the box. In addition, Sidoti didn’t follow through when it did implement policies. As we’ve seen, a deficient compliance program can cost a company dearly.
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